It’s Getting Tougher Out There (To Find Great Value)

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

By Rudi Filapek-Vandyck, Editor FNArena

At face value, the February Statement on Monetary Policy by the RBA offered something for the bears and for the bulls in the Australian equity market.

Firstly, there was the admission that previous prognostications had been too optimistic and economic growth in Australia is likely going to be weaker in the year ahead. Sub par. Below trend. Below expectations. Call it what you want, but weaker is the implication.

On the other end, the RBA also believes that further into 2014 the pace of domestic economic growth is likely to pick up again. If correct, the latter would be good news, albeit a little further out on the horizon.

The real good news is the RBA can still cut official interest rates in case short term weakness turns out worse than expected and this might well mean that the optimistic mood that has characterised the Australian share market in the opening weeks of the new calendar year can last much longer.

In an ironic twist of today's Zeitgeist, the longer there's an RBA with a loosening bias hovering over this market, the longer investors can continue to look forward to more monetary stimulus, the longer shares can be supported by the "tomorrow will be better" general state of mind.

After all, the universal catch phrase on Wall Street is: never fight the Fed. Investors will no doubt take the view that having the RBA on their side cannot be a bad thing either.

However, the revised economic outlook from the RBA also lays bare the big challenge investors are facing when making investment decisions today. What if Australia's economic performance cannot keep up, even with lowered expectations? Certainly economists at Westpac and National Australia Bank, to name but two, think the RBA remains too optimistic in its projections.

It's good to keep in mind that central bankers do not write the script for equity markets. Investors do. It remains an open question as to how they will respond when faced with disappointment first and good news later.

I can see arguments in favour of both good and less than good scenarios ahead. But with cyclicals such as Boral ((BLD)) now trading on 29.5x times FY13 consensus earnings per share (EPS) forecasts, and still at more than 15x times projected FY14 EPS, questions about has it all gone too quickly too soon will at some point appear on investors' mind, one would assume. Especially if housing activity data here and/or in the US were to be lower than expected in the weeks or months ahead.

Before we focus too much on the potential negatives, here are a few positive offsets to consider:

– Historically there is no direct correlation between economic growth and share market performance, unless we're heading for a new recession (see 2000 and 2008). Part of the growth prospects from cyclicals such as Boral comes from the fact that management teams are focused on reducing costs. This removes part of the risk the anticipated earnings recovery might arrive at a delay. Note that Australian banks are also still focused on taming their operational costs. So are BHP Billiton ((BHP)) and Rio Tinto ((RIO)).

– Domestic cyclicals in Australia, in particular industrial companies, have been operating under severe pressure post-2007. Last year, analysts at Goldman Sachs calculated they hadn't seen operational margins this low since the early 1990s. This implies that a little relief can make a big difference, let alone a little more than just a little relief. Imagine what can happen if both revenues start rising and those depressed margins start to normalise (expand). In other words: beyond the short term, the bias has to be in favour of positive surprises, more than stock analysts can possibly anticipate this early in the turnaround (assuming a positive outcome).

– Investors should also consider one major factor that has kept earnings pressures to the downside at many domestic exporters has been the Australian dollar. The RBA is pretty much impotent against international funds flows, but its easing bias must have contributed something to AUD/USD weakening from 1.06 earlier in the year to 1.02-1.03 in February. Every cent lower from here onwards is simply a free bonus for every profit result that was marred by the stronger-for-longer AUD momentum over the past years.

Offsetting these positive considerations are observations including:

– Global equity markets are arguably in full tunnel vision mode whereby all news is either interpreted in a positive manner or simply ignored or dismissed. With technical chartists observing markets have not shown Overbought signals for many years as strongly as they are doing in February 2013, one would have to assume that at some point a pause, at the very least, is on the cards. In share markets, a pause seldom means share prices simply go sideways for a while (it's not impossible, though).

– When The Herd is moving through a one-direction tunnel one common characteristic is that investors buy first and ask questions later. Maybe. Arguably, there's plenty of potential mayhem on the horizon, starting with budgetary and debt ceiling negotiations in the US, but also including a deteriorating economic landscape for France (to name but one in Europe) and ongoing nuclear ambitions in Iran. Always difficult to pinpoint exactly when the next cold shower is going to hit overheating share markets, but suffice to say the higher valuations have run up in the meantime, the more vulnerable they are when the next shock arrives. And cyclicals tend to be more vulnerable than others.

– Most basic materials, including iron ore, copper and crude oil, are facing a catch-up in supply later in the year. Is this the reason as to why the likes of BHP and Rio Tinto have largely trended sideways since early January? While smaller miners seem to have disconnected from spot price movements?

– Pricing in most if not all upside potential far in advance risks running into unforeseen bumps and hurdles down the track, with potentially negative consequences. One such fine example was provided by analysts at Citi who have warned that prospects for rising domestic gas prices in Australia in the years ahead are likely going to negatively impact on costs/operational margins for the likes of Boral, CSR ((CSR)), Fletcher Building ((FBU)), Incitec Pivot ((IPL)) and Orica ((ORI)); among others.

– Also, in Australia the share market outperformance (up 7% for the year already) has been largely fueled by money moving from the sidelines (cash) into dividend paying shares. Buying interest from these switching investors has been continuous, strong, and seemingly indiscriminate, meaning everything offering a decent dividend yield has participated in the rally. This also includes companies at risk of having to cut dividends later in the year or next.

Here's my personal list of companies likely to cut dividends this year (FY13) and/or next (FY14):

– Atlas Iron ((AGO))
– David Jones ((DJS))
– Fleetwood ((FWD))
– GUD Holdings ((GUD))
– GWA Holdings ((GWA))
– Graincorp ((GNC))
– Iluka ((ILU))
– Metcash ((MTS))
– Mount Gibson ((MGX))
– Myer ((MYR))
– NRW Holdings ((NWH))
– OZ Minerals ((OZL))
– Sigma Pharma ((SIP))
– Tabcorp Holdings ((TAH))

There are also companies that may well be rewarded if their Board decides to cut the dividend (sometimes hoarding cash is seen as a good thing) such as Arrium ((ARI)) and Resource Equipment ((RQL)).

Here are Goldman Sachs' recommendations for investors still seeking yield in today's share market ("Quality Dividend Growers"):

– UGL ((UGL))
– Toll Holdings ((TOL))
– Insurance Australia Group ((IAG))
– Incitec Pivot
– Coca-Cola Amatil ((CCL))
– Woolworths ((WOW))
– Flight Centre ((FLT))
– Super Retail ((SUL))
– Sonic Healthcare ((SHL))
– Amcor ((AMC))
– Henderson Group ((HHG))

– There's still the obvious, but seldom mentioned, risk that investors, economists and central bankers worldwide will once again be proven too optimistic on the global economy later in the year and in 2014. It's not that it hasn't happened before as we all experienced in 2010, in 2011 and in 2012. Under such scenario the key question will shift as to whether Quantitative Easing by central bankers will continue to support global equities.

All this now leads us to a Big Dilemma for investors who do no longer feel comfortable to jump on the bandwagon for cyclical stocks given share prices for the likes of Boral have already jumped by 66% (including payout of half-yearly dividend) since late June last year, regardless of the potential more upside that may pop up on the horizon (nothing in the share market ever comes risk free).

For these investors the logical answer to their dilemma remains: seek strength. Because many of the strong business models have already been rewarded with a higher valuation throughout this rally, the answer has to come with the following caveat: at still a reasonable valuation.

Strong business models that still trade at reasonable valuations (on my observation) include Flexigroup ((FXL)) and ResMed ((RMD)).

All-in-all, it's getting tougher out there to find great value post the share market's strong run.

Just as a side-note: I believe the strong will continue to stand out during the reporting seasons in February and in August this year, showing ongoing strong results whereas investors in vulnerable cyclicals will have to keep the faith for a while longer.

As per usual, strong business models whereby companies are experiencing an operational sweet spot are complemented by a small, select group of All-Weather Performers. These stocks are essentially facing that same problem of a potentially inflated market enthusiasm post their blatant outperformance in the post 2007-era. On my observation, All-Weather performers such as Coca-Cola Amatil, McMillan Shakespeare ((MMS)) and Ansell ((ANN)) are still not looking extremely expensive.

What both these latter two groups of companies have in common is that risks to the downside remain benign, while built-in strength and market confidence virtually guarantee the share price will move higher in the year(s) ahead.

(This story was originally written on Monday, 11 February, 2013. It was published in the form of an email to paying subscribers on that day)

DO YOU HAVE YOUR COPY YET?

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P.S. My research received a brief mentioning in The Australian Newspaper last weekend: Wealth Section, page 28, left column, All-Weather stocks.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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Rudi On Tour in 2013

– I will visit Melbourne next week for a presentation on invitation by the local AIA branche. Title: "The Big Confusion that is the share market". When: Tuesday 19th February 2013. Where: Telstra Conference Centre, Level 1, 242 Exhibition Street, Melbourne

– I will visit Perth in March for two presentations both on Tuesday March 5: ASA first at noon and AIA later in the evening (7pm)

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